Why a cut in interest rates may not save Sunak

Even if voters start to feel better off as the election approaches, it is likely to be too late for the Tories, writes Eir Nolsøe

Bank of England top official Huw Pill did something unusual last week. As central bankers in the world’s largest economies carefully insist they may still raise interest rates further, Pill went against the tide. He became the first policymaker in the UK to suggest that they could soon fall.

Traders who have long been speculating about when this moment would come seized on the comments.

They largely ignored subsequent remarks by his boss, Andrew Bailey, protesting that it was “really too early to be talking about cutting rates”.

Even as Bailey sought to put the genie back in the bottle, markets have ramped up bets of interest rates falling from their 15-year high of 5.25pc to 4.75pc by September next year.

Yields on two-year gilts, which are highly sensitive to borrowing costs, also remain lower than at the start of the week and are close to levels last seen in June. For Rishi Sunak who will soon lead the Conservatives into the party’s most challenging election in decades, weakening price pressures and the prospect of lower interest rates present a glimmer of hope.

It comes as inflation next week is expected to fall well below 5pc when October’s figures land, down from 6.7pc the previous month. This would see Sunak hit his pledge of halving inflation by the end of the year early.

Talk of falling interest rates “is not something which you would often hear at the moment from central bankers anywhere,” says Philip Shaw, the chief UK economist at Investec.

Pill’s unexpected remarks were a “crack in the messaging”, he says.

Policymakers in the UK and abroad have been very careful to emphasise that rates will have to stay “higher for longer” even as the Bank of England, the Federal Reserve and the European Central Bank have stopped hiking.

But history suggests that after reaching the terminal rate, even if central bankers talk the talk they seldom walk the walk for long. Over the past 100 years in the UK, the median gap from the last interest rate increase to the first cut has been four months, according to Deutsche Bank research. The Bank of England last raised interest rates in August to 5.25pc, its 14th consecutive rise since December 2021. Its policymakers then warned borrowing costs could remain above 5pc until 2026.

In contrast, Pill said that market expectations of rate decreases by the middle of next year were not “unreasonable” during a Q&A with the public on Monday.

Two days later he struck a more careful tone but maintained that interest rates would not need to rise further, despite Bailey the week before saying he was watching closely for signs that another hike was needed.

“Even if the Bank of England thinks it might need to cut from Q2 of next year, it probably doesn’t want the market to figure that out until late Q1 – once we’ve got inflation probably at 3pc,” Kallum Pickering from Berenberg says. This kind of forward guidance is in itself a way for central bankers to contain inflation, as mortgage rates are influenced by how markets interpret such signals.

Some economists warn, however, that for this reason Pill’s remarks could backfire. “It seems a bit premature to make this announcement at this stage because we’re not there yet. We may be there by the summer but the last thing you want at this stage is to get a premature easing in monetary conditions because you still want relatively tight monetary policy.

Otherwise, you’d need to start raising rates again,” Yael Selfin from KPMG says. Pickering is betting on rates falling by as much as 1.25 percentage points next year.

While this is more than most economists expect, rate cuts are widely predicted next year. Markets are currently close to pricing a cut in by August and expect one in September. “They won’t cut quickly,” says former rate-setter Michael Saunders. But he adds: “If the economy is flat then even if pay growth is still above a target consistent pace, they may prepare to edge rates down on the grounds pay growth will be likely to slow further.”

Saunders was on the Bank’s Monetary Policy Committee until last summer and is now an adviser at Oxford Economics. He is expecting two rate cuts – one over the summer and the second towards the end of next year. He says the Bank of England will want to see headline inflation falling comfortably, wage growth easing and a weakening of the economy to start taking the foot off the brake. Pay has been growing at record pace above 8pc over the summer when including bonuses. Growth has started to falter under the weight of interest rates at their highest level since early 2008 however, with the economy flatlining in the three months to September.

Sunak is expected to call an election for autumn next year, having to fight for his political survival as Labour remains 24 percentage points ahead in the polls. He also faces the challenge of his party having lost its reputation for economic competence after the scandalous mini-Budget, with voters more inclined to say Labour would be the best at handling the economy.

“Typically in an election campaign a recovering economy, falling inflation and decreasing interest rates tend to help the Government and we’re expecting all those things to occur over election time next year. The question is: is it going to help the Conservatives sufficiently to enable them to beat Labour and with a gap of 20 points in the polls?” says Shaw.

Borrowing costs are particularly important in blue wall seats, where the concentration of mortgage holders tends to be highest. These are areas, typically in the south of England.

Many borrowers are still anxiously waiting to refix their mortgages at much higher rates. Falling market expectations of interest rates will limit the blow slightly, but for those coming off deals of 1pc or 2pc it will still be a bitter pill to swallow.

Shaw says that while rate cuts are unlikely to provide a massive boost to the economy before the election, “none the less it’s a help”.

Another factor in Sunak’s favour will be that wages are growing faster than inflation and are expected to do so for some time, meaning households are regaining some spending power.

But whether Sunak could get a boost from falling borrowing costs will crucially hinge on why they are going down, says Pickering.

Saunders expects they will come down for the wrong reasons, meaning any help for Sunak will be limited. “It’ll be because the economy is flat.”

Yet any little sign of things improving will be welcome for Sunak as he fights to restore the party’s image as economically competent. Going into an election at a time when real incomes are rising and mortgages are gradually becoming cheaper could help him narrow the gap. But it may have come too late for the Tory leader.

“I think the most likely outcome, although it’s certainly not guaranteed, is that Labour wins and they inherit an economy with falling interest rates, low inflation, a falling deficit and a recovering real GDP growth rate,” Pickering says.

‘The last thing you want is to get a premature easing, otherwise you’d need to start raising rates again’